Distribution of Partnership Income
Net income earned by a partnership is distributed to partners in a number of forms which includes salaries, interest on opening capital balances and/or in the form of share in the remaining net income.
A partnership agreement may allow some partners' a specific salary in addition to their ultimate profit share. For example, when one partner is contributing more time to the partnership than the other partners he might be entitled to an exclusive salary to compensate him for the additional time.
Salaries paid to partners is not an expense of a partnership rather it is just a form of distribution. This is why partners' salaries are not deducted from revenues in arriving at partnership net income. Partners' salaries are recorded by debiting partnership income summary account and crediting the respective partner's capital account.
Interest on partners' capital accounts
A partnership deed may also specify that partners are to be compensated for their capital balances at a specific rate of interest. For example, it might be a situation where some partners have contributed more capital than other partners and the ultimate profit sharing ratio is not based on opening partner capital.
Like partner salaries, interest paid to partners is not a partnership expense but is a distribution of partnership net income. It is accounted for by debiting partnership income summary account by the total interest (even if it is greater than the total credit balance available in the partnership income summary account) and crediting the respective interest account to each partner capital account.
Share in the remaining partnership income
After the salaries and interest on capital accounts have been charged, the remaining partnership profit is distributed to the partners in their respective profit sharing ratios by debiting the partnership income summary account and crediting each partner's capital account with its share of income.
Nile, Indus and Ganges are partners in a public accounting and consulting firm called NIG. They started the firm back in 1998 and their current capital balances are $40 million, $30 million and $30 million respectively. Nile is the senior partner and gets the 50% share in the profit or loss and the rest is shared between Indus and Ganges in equal proportion. Indus is technically the most knowledgeable of them and is considered the ultimate authority on complex transactions. He works more hours than Nile and Ganges for which it is compensated in the form of an annual salary of $3 million. Each partner is entitled to interest on capital at the rate of 6% per annum. NIG's profit for the year before any distribution to the partners amounts to $20 million. Distribute the partnership income according to the arrangement explained above.
The first distribution would be of salary of $3 million to be paid to Indus. This is recorded by the following entry:
|Indus Capital Account||3,000,000|
Second distribution is the interest paid on opening capital balance. At the rate of 6%, annual interest to be credited to Nile, Indus and Ganges' capital accounts comes out to be $2.4 million, $1.8 million and $1.8 million respectively. It is recorded by the following journal entry
|Nile Capital Account||2,400,000|
|Indus Capital Account||1,800,000|
|Ganges Capital Account||1,800,000|
After charging $3 on account of partner salary and $6 million on account of interest on partner's capital accounts we are left of remaining net income of $11 million ($20 million minus $3 million minus $6 million).
This $11 million is distributed in the ratio of 40%, 30% and 30% for Nile, Indus and Ganges respectively. The journal entry for this distribution would be:
|Nile Capital Account||5,500,000|
|Indus Capital Account||2,750,000|
|Ganges Capital Account||2,750,000|